Imagine you’re a smart young rich kid. You invent a money-printing machine. You use it to magic up money to buy $100 in assets. It turns out, though, you didn’t make a great investment and the assets end up being worth on $90.

Do you (a) Be grateful that you’re $90 better off or (b) Call up your Dad to tell him you need $10 to make up your losses?

The debate about potential ECB asset purchases continues to focus incessantly on the issues surrounding potential losses, with the ECB playing the role of the rich kid asking his Dad for an unnecessary bailout.

Take this from my old mate Hans Werner Sinn (via Constantin Gurdgiev).

Apparently tax-payers will have to make up for a shortfall of profits from the ECB if there are losses on ABS purchases. In saying the ECB will have reduced profits, Sinn focuses solely on losing the $10 and forgets about the $90 profit.

One could question whether money creation by the Eurosystem is really just pure profit. Doesn’t this expand the supply of liquidity to the banking system, increasing the amount of money on deposit with ECB and thus increase the interest payments it has to make to banks? Not now – the ECB currently charges banks to keep money on deposit with it so this factor now actually raises the profitability of money creation. (Interest on reserves is also not a necessary feature of a central bank operational framework – the Fed managed fine without it for years.)

I think there are two reasons there is so much confusion about these issues.

The first is the arcane way that central banks do their accounting. All money that is created is counted as a “liability” even if, like bank notes, it doesn’t actually ever impose a cost. Central bank capital measures based on subtracting reported liabilities from reported assets thus grossly underestimate the true financial value generated by central banks. (See here for a more detailed discussion).

Central bank profit and loss measures are calculated in line with this wholly uneconomic methodology. In the analogy above, the central bank would report a $10 loss because its assets had increased by $90 while its “liabilities” had increased by $100. Reporting a loss in these circumstances doesn’t actually make any economic sense but is sure to generate lots of hand-wringing from people who imagine something terrible has happened.

The second problem is the widespread failure to understand that central banks are fundamentally different from commercial banks. Central banks do not need to have assets greater than liabilities and cannot “go bust” due to losses on asset purchases. That said, most of the international policy community seems happy to perpetuate this myth.

For example, consider this Very Serious report from the BIS last year. It recommends that central banks should maintain positive capital, not because they need to, but because the public might be confused about this stuff and so it’s best not to get them too concerned. A quick flavour of the thinking:

«we have no doubts about the central banks that are currently shouldering extraordinary financial risks. But our confidence is based on an understanding of the special character of central banks that may not be shared by markets and others.»

So if financial markets believed central bankers needed to wear Hawaiian shirts, would it be best to ditch the suits and start drinking pina coladas at press conferences?

There may be another case where an international policy organisation recommends an incorrect policy solely because private investors believe strongly the incorrect policy must be solved, but I can’t think of one offhand.

These points are not intended as a recommendation for central banks to purchases whatever assets just take their fancy. There is an important opportunity cost here. For example, the money could have been distributed to the public by providing each person with a fixed amount of money. So it’s important that the purchases are made in a fair and transparent way using market prices.

The other cost usually cited is that money creation may lead to inflation. But in the case of the ECB’s ABS purchases, this is a feature not a bug. The whole point of it is to raise inflation back to the ECB’s target level. The fact that the programme also fits with the ECB’s secondary goal of supporting the general economic goals of the EU is welcome but not crucial.

Anyway expect lots more of this stuff over the next few months as the widespread lack of understanding of central bank balance sheets continues to see irrelevancies held up as crucial economic principles.

As the ECB takes a more active role in battling the ongoing slump, Mario Draghi has intensified his rhetoric about structural reforms. The transcript of his September press conferences shows fifteen uses of this phrase. Draghi now says he has “concluded that there is no fiscal or monetary stimulus that will produce any effect without ambitious and important, strong, structural reforms.”

It is hard to find a logic (at least one based on macroeconomic theory as we know it) for this argument. It is certainly the case that potential output growth in the euro area is currently low and can be improved by various policy reforms. However, it is also true that there is currently a very large shortfall between aggregate demand and the current supply potential of the euro area economy, a shortfall summarised in an unemployment rate of over 11 percent. So there is room for fiscal and monetary stimulus to boost the economy, even without structural reforms. In addition, to the extent that we are worried about deflation, the initial impact of structural reforms that boosted the supply capacity of the euro area would be to further depress inflation.

My point here is not to argue against structural reforms. There are many such reforms that can have an important positive effect over the medium- and longer-run (though we know little about the magnitude of their potential impact). But it is important for the ECB to take responsibility for its crucial role in the shorter-term macroeconomic management of the euro area and ECB officials continually placing structural reforms at the heart of discussions of this issue is unhelpful.

Irish government politicians have been keen to claim that there is some good economic news in this announcement, that it “provides clarity” and “reduces uncertainty”. In fact, the opposite is the case.

A precautionary credit line is something that doesn’t have to be used. Anything that can be done without a precautionary credit line can also be done with one. However, without such a credit line, the Irish government run the risk of running out of funds and having to negotiate a new bailout or credit line under far less positive circumstances than currently prevail. This adds to the uncertainties facing Ireland in the coming year, particularly given the possibility that Irish banks may need further recapitalisation next year.

Ireland’s finance minister, Michael Noonan, acknowledged yesterday that economic conditions may not be so benign next year. This should be seen as an argument for negotiating a credit line now but, strangely, Noonan used this observation as an argument for not seeking a credit line. He seemed to be struggling to find anything better than weak talking points to explain the benefits of not having a credit line.

There is, of course, a narrow political benefit to the Irish government from this “clean” exit, because it allows them to triumph about the full restoration of “sovereignty.” However, I don’t think they are so cynical as to have made this decision purely for that populist reason. Instead, my assessment is that the precautionary credit line could not be arranged now because it was politically impossible and that the Irish government are merely putting a brave face on what is a bad outcome.

The political problem is that credit lines from ESM require the approval of all euro area member states and this was not going to be possible now. Germany still does not have a government as Angela Merkel’s CDU continue negotiations with the SPD to form a coalition. During these negotiations, the SPD has regularly insisted that they would not support an ESM credit line for Ireland unless the country followed a series of highly specific policy recommendations.

This kind of micro-managing of other people’s economies was not what most people had expected ESM conditionality to look like. Given the existing raft of EU monitoring programs that exist (the six pack, the two pack, the macroeconomic imbalances) a sensible approach would be to require that a country seeking a credit line from ESM commit itself to meeting the recommendations on macroeconomic policy of the European Commission.

When Germany finally has a government and SPD politicians are firmly ensconced in ministerial Mercs, I suspect the desire to micro-manage Ireland’s affairs will recede. However, the damage may well be done. Having sold the Irish public on the idea that the credit line was something to be avoided, it seems unlikely that the government can change its mind next Spring.

This is the odd aspect of yesterday’s decision. Why not announce that Ireland was exiting the program without a precautionary credit line but that discussions about this issue were ongoing? One unattractive possibility is that Ireland’s leaders were asked by their German colleagues to make this announcement to remove it as an issue in the government formation negotiations.

Missed in yesterday’s discussion is that these developments have implications for the ECB’s Outright Monetary Transactions (OMT) program. This is the program announced by Mario Draghi after his “whatever it takes” speech last year. Under this program, the ECB can purchase unlimited quantities of a country’s government bonds. However, the ECB decided that countries could only avail of OMT if they had an agreement with ESM for a bailout program or precautionary credit line.

Ask yourself this: If star pupil Ireland couldn’t negotiate a precautionary credit line based on reasonable conditionality, what chance is there that a credit line of this sort for Italy will be approved by all countries in the euro area? OMT may have been cast as the plan to save the euro but getting it up and running may not be so easy.

Some of the coverage of today’s events in Cyprus has been drawing the conclusion that the plan to restructure Cyprus’s banks is going well because there has been no “bank run”. However, the only reason there isn’t a massive bank run in Cyprus today is the imposition of severe capital controls (full details here).

The controls have frozen accounts over €100,000 in Cyprus’s main banks and have limited cash withdrawals to €300. The large deposit withdrawals that really destroy a bank are not possible. And most ordinary people in Cyprus know full well there is no point in queuing up to withdraw all their money because such withdrawals are not allowed. Hence, no bank run.

As it is, it is hard to see how the capital controls can be lifted without a complete reworking of Cyprus’s agreement with the EU. Depositors with over €100,000 still do not know how much they are going to get back, while those with under €100,000 may still feel worried that their turn to take a hit may come around again. The likely collapse of the economy may trigger a sovereign default which would further hit the banks and further increase creditor losses.

The capital controls could be lifted if the ECB allowed the Central Bank of Cyprus to provide unlimited amounts of Emergency Liquidity Assistance to facilitate massive deposit flight. However, neither the ECB nor the Central Bank of Cyprus are likely to be interested in doing this. The ECB are very touchy about allowing ELA and worry a lot about how to end such programs. The Central Bank of Cyprus are aware that they are supposed to take the credit risk associated with ELA lending which differs from regular Eurosystem lending in which the risks are shared among participating central banks.

For these reasons, the capital controls are likely to remain in place. As long as they do, Cyprus is a member of the euro in name only.

As long as Cyprus is a member of the euro in name only, the question will remain as to whether it can ever return to being a normal member of the euro or whether it will be better off to set up its own currency.

One way to ease a return to Cypriot euros being equal to euros elsewhere is for Europe’s leaders to reverse course on Cyprus. This would involve ESM taking over the Cypriot banks and putting in enough money to ensure these banks are well-capitalised and safe beyond question. Since this outcome seems unlikely, Cyprus’s euro membership seems to hang in the balance. The fear that capital controls are coming to their country will also be influencing behavior in other euro area countries in the coming weeks.